Up With Federalism? A Case for Cautious Optimism

The pandemic has cast a spotlight on our federalism’s warts but also its considerable virtues. Governors such as Andrew Cuomo (NY), Mark DeWine (OH), and Gavin Newsom (CA) have commanded center stage as effective crisis managers. They have cooperated on a regional basis and across partisan lines. And after a brief hubbub over the President’s idiotic musings about commanding state governors, a modicum of good sense has descended upon this great country and its creaky institutions: state governments will play the lead role in re-opening the economy.

The timing and nature of those measures, like the immediate and the flatten-the-curve responses, will vary greatly. That makes eminent sense in a vast, diverse country—especially when, as here and now, you really have no idea what you’re doing and the crisis ranges from horrendous in New York, New Jersey, and handful of other metro areas; to manageable in most of the country; to negligible or non-existent in vast rural areas. (My buddy Tom Haynes has terrific analysis, updated daily, on Twitter.) The question is not whether some mayor in Minnesota acts a little bit psycho; it’s whether a wholly centralized response would be more effective. The answer is “no” (and do not say, “it worked in Singapore and South Korea”—looked at a map, lately?) A federal system will produce friction and error costs, but also a great deal of resilience. States have learned and will continue to learn from each other, and we will collectively learn valuable lessons for the next of these rodeos. But for the over-the-top Trump encomia, I’m totally with Chris DeMuth: we somehow seem to remember the lessons of a free society; and in our own half-baked fashion, we are acting on them.

There remains, however, the serious question of whether the lessons will stick—whether we can emerge from this nightmare with a greater appreciation of federalism’s virtues; with more robust, confident state and local governments; and perhaps, just perhaps, with legislative reforms at all levels that would permit us more easily to mobilize the astounding resources of a blissfully disorganized governmental system in good times as well as bad—for starters, by permanently repealing laws and regulations that have now been suspended and were never needed in the first place (by my rough estimate, half the U.S. Code and the Code of Federal Regulation).

On that score, alas, the only comparable experience in living memory, the 2008-2009 financial crisis, suggests caution. To be sure, that was a different kind of crisis. But in many unnerving respects, and especially in fiscal respects, it resembles the late unpleasantness. Then as now, state and local governments were hit from every direction. Tax receipts, way down. Expenditures, way up. Muni markets, in a deep funk. Pension systems, hopelessly under water. No sense in rehearsing the exact numbers; suffice it to note that this time will make the financial crisis look like a hiccup. E.g., unemployment in 2009 peaked at 10.1 percent. We’re well past that; and you ain’t seen nothing yet.

The federal responses to the calamities, too, look uncannily similar. Back then, Congress enacted the American Recovery and Reinvestment Act (ARRA), which did not “reinvest” in much of anything but instead dished out some $140 billion in debt relief for beleaguered state and local governments, including some $48 billion “stabilization” funding for “education” (as distinct from students or their parents. Intergovernmental grants routinely end up with local governments and their cronies, such as the teachers’ unions). Congress temporarily enhanced the federal share of Medicaid expenditures (“FMAP”). And, Congress created taxable but heavily subsidized “Buy America Bonds” to prop up state and local borrowing.

Crises of these proportions will lay waste to even the best-run, most responsible state or city.

Sounds familiar? Debt relief: check. (We’re well past double-ARRA already now, for all the usual suspects: unemployment, education, health services, and public transportation.) FMAP increase: check. (6.2 percent—contained, if you must know, in Section 6008 of the Families First Coronavirus Response Act). Build America Bonds: nope; but they’ve hit upon a different way of sustaining state and local borrowing. Under the CARES Act, the U.S. Treasury is authorized to fork over $35 billion to the Federal Reserve to establish a Municipal Lending Facility (MLF) to purchase state and local debt issues. While the Fed so far has been a bit prissy about the MLF—e.g., by limiting purchases to large cities and counties and by insisting on collateral in the form of future tax obligations—chances are that that will soon end. They’ll leverage the risible equity 15-1; lend to deadbeats (Chicago) whose tax collections have already been obligated five times over; and then suspend payment obligations.

(How do I know this? Because numerous legislators have since proclaimed this to be the true intent of Congress. And because institutional investors and Wall Street bottom-feeders will demand it. In 2010, when Build America Bonds ran out, they amounted to over one-third of new muni issues. Given the sheer scale the Fed will have to do better this time around. Mr. Mayor, meet your new boss: Jerome Powell.)

Crises of these proportions will lay waste to even the best-run, most responsible state or city. So you’ll want to close your eyes, print money, and send it along. Moreover, unlike the 2010 Dodd-Frank Act and its Frankenstein creation, the Consumer Financial Protection Bureau, the post-2008 fiscal federalism measures were miraculously permitted to expire. When, though, did state and local governments recover from the crisis?

How about, never? As the Pew Trust has explained in a concise, balanced analysis, the post-crisis years were a “lost decade” for state and local governments. Tax collections never fully recovered. State government employment, in the aggregate, remained down. Higher-ed funding: down. The libertarian devil on my shoulder whispers that those may be good things. But other things are unambiguously bad. Dreadful under-spending on infrastructure across the states, for example. And despite an extended economic recovery, record-low unemployment (pre-virus), and a spectacular Fed-fueled stock market boom, state and local pension systems are in far worse shape—underfunded, by conservative measures, to the tune of $1.5 trillion—than they were in 2007. You begin to wonder how some of theese places manage to hang on.

The answer is what federalism experts delicately call the “vertical fiscal imbalance,” meaning the federal transfers that cover the yawning gap between the states’ revenue capacity and their expenditures. The federal share of state expenditures increased from about 23% at the end of the Reagan administration to 28% by 2006 and then rocketed to 35.5% in the 2008-2009 financial crisis. It then dropped back but soon accelerated again.

Annual federal transfers under some 1,200 programs (no one knows the exact number) now clock in at over $750 billion. The principal fiscal-imbalance driver, especially in the wake of the Infernable Care Act, has been Medicaid. (The feds pay over 60% of all Medicaid spending.) Medicaid and associated health programs make up about 60 percent of federal transfers, and those expenditures were expected to double in a little over a decade before Covid-19, which will add many millions of people.

Care to guess what will happen to the fiscal imbalance over the next decade? To state finances? The aggregate data, to be sure, conceal vast state-to-state differences; and they come with a big asterisk for the Basket State (Illinois) and another asterisk for its metropolis, whose hapless denizens will need really broad shoulders in years ahead. But even the averages are daunting. You cannot run your own state, really, when one-third or more of your general fund revenue comes from the feds—as it now does in a majority of states.

The natural intuition is to think that federalism works in normal times, when courageous little states and their public-spirited servants experiment in a Brandeisean fashion; and then gets in the way of prompt, effective responses to crises that exceed local capacity. But maybe it’s just the reverse. Maybe federalism works best in crisis times, when there is a high premium on promptness, local knowledge, and adaptation. And maybe our federalism—as currently configured—tends to work its pathological worst in ordinary times, when the system succumbs to the moral hazard that naturally accompanies federal transfers; chronic overspending on consumption; wild-eyed pension promises; fiscal shenanigans; and political lock-ins, on account of federal transfers that are the lifeblood of nominally local constituencies.

If that apprehension is roughly right, you have to hope that even the Covid-19 mushroom cloud has a silver lining. Maybe the governors who now look like heroes won’t want to revert to their normal posture of obnoxious beggars. Maybe state attorneys general will quit litigating for yet more federal mandates. Maybe Congress will despair of having state and local bureaucracies siphon off billions of transfer payments and instead cut checks directly to people in need. Maybe public finance geniuses will stop insisting on the need for “counter-cyclical” spending by already-insolvent state and local governments. And maybe the confidence that the public has placed in state and local institutions will endure. None of that is certain, and systemic reforms would require a great deal of political fortitude and good will on all sides. But for the first time in a very long time, there is reason for hope.